Sunday, 29 November 2009

My previous twoposts make it clear that all the conditions are in place for a bond bubble: strong fundamentals, technical momentum, and a mechanism for positive feedback. But these conditions are merely necessary; they are not in themselves sufficient to generate or identify a bubble.

Nonetheless there are certain indicators that suggest we may be entering bubble territory.

Let’s start by looking at the fundamentals again. One sign that a market has transitioned from boom to bubble is when the fundamentals change from bullish to bearish, but prices keep rising. I believe that this is true for the bond market. Let’s consider each of the factors I identified in my earlier post, in order:

1. Monetary policy seems to have regressed in recent years. In particular, central banks are no longer strict inflation-targeters; they have become asset-price-targeters instead1. Central banks are also less independent than before2. Finally, central banks have explicitly moved from trying to head off crises, to merely reacting to them3. This reaction invariably takes the form of overly easy monetary policy, since policy-makers and politicians alike seem incapable of accepting short-term pain for long-term gain. Each of these is a backward step, in my opinion.

2. Since the fall of the Berlin wall and the ‘end of history’, the US has become embroiled in two expensive new wars, in Iraq and Afghanistan. In addition, entitlement spending (especially social security and health care for retiring baby boomers) will put a significant burden on the government’s fiscal position in the years to come. And a dysfunctional political process renders this trajectory very difficult to change.

4. China may not export disinflation for much longer. Western politicians, pundits and plutocrats have been unanimous in calling for China to consume more and/or to revalue its currency upward, in order to reduce the global imbalances that (supposedly) lay behind the recent crisis. Either of these shifts (an increase in Chinese domestic consumption or an increase in the RMB/USD exchange rate) would be dramatically inflationary for the United States4.

5. The commodity supercycle is now in its bullish phase.

6. Increased regulation (for which there is plenty of momentum) could see a rollback of innovation, especially financial innovation.

Now, figuring out the impact of (changes in) fundamentals on asset prices is a tricky business. It’s very difficult to know how important any given factor is in determining bond yields; it’s also very difficult to know the extent to which any given factor has already been priced into the bond market.

Fortunately, my argument does not depend on my ability to perform either of these tricks. My point is much simpler. Every single fundamental factor that has driven the 30-year decline in bond yields has either weakened appreciably, or reversed direction. Yet bond yields continue to decline!

What’s going on here?

Well, for starters, many of the technical forces I identified earlier are still in play: Bretton Woods II (developing country exporters continue to finance the US twin deficits); baby boomer portfolio changes (stocks as a retirement haven are understandably less attractive now then they were a few years ago); and post-crisis risk aversion (unemployment and consumption data suggest we are still not out of the woods).

But in addition to these relatively ‘benign’ technicals, some rather more dangerous forces have come into effect.

First, ‘reflexive feedback’ has kicked in, as Wednesday’s post makes clear. Low long bond yields create the justification for the Fed to keep overnight rates low. And low overnight rates create the motivation for investment banks to buy long bonds.

Second, the ‘greater fool theory’ has kicked in: there’s certainly an element of it in foreign central bank purchases of US government debt. Various acronymic entities like the BOJ, SAFE, ADIA and so on know full well that if they don’t take down Treasury’s flood of new supply, their existing holdings will be mullered.

(As an aside, the fact that foreign CBs are price-insensitive buyers is often quoted as a justification for the low level of yields, whereas in fact it is a symptom that yields are in non-economic territory.)

Third, commentators have begun to emerge claiming that “this time it’s different”, most notably those whose belief in American exceptionalism blinds them to the parallels with Britain a century ago or Spain somewhat further back.

A fourth suggestive indicator is the level of supply. All true bubbles are characterized by dramatic increases in supply, which seem to have no impact on prices (until of course the bubble collapses). The Treasury market clearly embodies this dynamic: the August 10-year note, for example, had a float (after reopenings) of 67 billion. That’s more than the entire government of debt of say Switzerland or Australia. Just one single bond.

Put it all together, and the conclusion is obvious: we are entering a regime where fundamentals don’t matter any more; a regime in which technicals, feedback and short-term (institutional) considerations dominate the price action; a regime where supply has crossed the line from the impressive to the insane. In short, a bubble.

Footnotes

#1 We used to have a Greenspan put; now we have a Bernanke put; but there was never a Volcker put. I explain the link between Fed policy and asset price bubbles here.

#2 Witness the close cooperation between the Fed and the Treasury in rescuing Wall Street banks in 2008 – this could have come straight out of the Arthur Burns / Richard Nixon / Penn Central playbook. It’s not as if the Fed has much choice in the matter; see the last two paragraphs of this post for more.

#3 A view reflected in ex-governor Mishkin’s recent comments on identifying bubbles, which I review here.

#4 Actually, that’s sort of the point. Inflation is a monetary phenomenon; an increase in US inflation necessarily means a debasement of the currency, which is precisely what the US needs if it is to reduce its twin deficits.

Also, note that if China does boost domestic demand, revalue its currency or otherwise plug its trade surplus with the US, an immediate and necessary consequence would be a decline in Chinese buying of US Treasuries. And if China backs off, who will finance the US budget deficit? One more bearish indicator for bonds.

Thursday, 26 November 2009

This is a bit belated - I started it, and then didn't finish before all family got here for the festivities. But better late than never, eh?

Here's hoping you all had a Happy Thanksgiving. It's a good exercise to occasionally thing about the things we're thankful for, so here's a few of the things I'm particularly thankful for:

My Family - I somehow managed to marry well above my station (the Unknown Wife is far better a person than I deserve, with the exception of her poor taste in spouses), I have a nine year-old daughter who still thinks her dad is pretty cool (I figure I still have another year on that score), and a very good-natured 8 month old baby boy (yeah, I'm too old for this stuff, but it's still pretty cool).

My Job - I love being a professor (well, at least most of the time). I spend my workday with smart people, I get to learn interesting things about topics of my choice (they call it research), and teaching is pretty fun. And they pay me well and give me lots of time off.

Where I live - I live in a beautiful area, in a nice neighborhood, in a relatively new house less than two miles from my office, and both my and the Unknown Wife's family are within two hours' drive (in fact, they were here for Thanksgiving Dinner), and we visited my mom last weekend.

My health - while I have a few things that'll eventually need fixing, I'm basically healthy. And I live in a time where replacement parts are getting better, more available, and cheaper all the time.

My church - As evangelical born-again Christians, having a good church to attend is very important to us. We are fortunate enough to have a great one - a good preacher, good worship (our worship band kicks some serious hiney), and people who get involved in each others' lives in good ways.

My country - the USA has problems (after all, it's populated and run by people, and people are inherently messed up). But over all, I think it's the most amazing place in the world. We're an incredibly wealthy country, with more freedom (still) than any place else, and there's always opportunity for those willing to take advantage of it.

The times we live in - The advances in almost any field over my lifetime astound me. We can now cure things that would have been a death sentence thirty years ago: to give you just a few examples, the Unknown Son wouldn't have lasted a year back in 1980 (instead, we got an additional five years), AIDS has become a manageable disease, and they can do heart surgery on babies in the mother's womb. As far as technology, I'm old enough to recall the original Star Trek in the 70s. Now we all have our own "communicators" (cell phones), I don't know anyone (including my students) without a microwave and color TV, and I'm posting a message that will be read by people all over the world on a machine that's many thousands of times more powerful than the computer that was used in the original space program.

As regular readers know, it's been a Hell of a year (and I do mean "Hell"), what with the Unknown Son losing his battle with cancer in June. But even with that, there are things to be thankful about. When he was diagnosed, it looked like he wouldn't last a year, as the cancer was both aggressive and resistant to treatment. But we had another five years with him, and got to see him grow into an amazing ten-year old boy. And we got to see his excitement at his new baby brother (and to see him relate to him for two months). In fact, here's a picture (it's the desktop background on my computer):

One of my favorite blogs (the Aleph Blog) is run by David Merkel, a CFA charter holder, portfolio manager and fellow Christian with eight kids. He just put up his own Thanksgiving post, and in it he mentions Job - the one book of the Bible that there never seem sot be a good time to read: when you're happy, it can bring you down, and when you're down, it can be even worse.

For those of you who aren't "people of the Book", it's about a wealthy, happy, and religious man who God allows Satan to test by taking everything from him - his wealth, his family, and even his health.

At the end, Job decides two things - that God is beyond his understanding, and that he'll still praise him regardless of his circumstances. So at the end of the day, being thankful is a choice. I've noticed that there are people who are generally happy and thankful, and those who aren't. More often than not, when I ask the happy ones why, the only common answer is that they simply choose to be happy.

Wednesday, 25 November 2009

There are three types of positive feedback in the market: irrational feedback, rational feedback, and reflexive feedback. To distinguish between these, let me quote a previous post at length:

In a bubble, the dominant mechanism is positive feedback; the key to understanding bubbles is understanding this positive feedback. How, then, does positive feedback arise?

The most obvious explanation is the conventional one: positive feedback is a consequence of irrationality in the market. And there’s certainly an element of truth in this explanation. Greed, self-delusion, unjustified extrapolation, caring more about relative returns than absolute profits (a.k.a. “keeping up with the Joneses”), conformism (a.k.a. “if everybody else is doing it why can’t we?”), confusing the improbable with the impossible (“house prices will never go down nation-wide”) and other persistent behavioral flaws lead inevitably to bubbles. This has been true throughout the history of speculation.

Both of these are what I would call ‘technical’ explanations, in that they depend on trader behavior (which has various causes) to move market prices away from some underlying fundamental value. But there is another, and to my mind more interesting, form of positive feedback in which the fundamental values themselves change.

Consider this example from the FX markets. A currency strengthens. This acts like a tightening of monetary policy. Hence inflation expectations diminish. Hence the currency strengthens further. The initial move has thus changed the underlying fundamentals so as to justify itself; it has become a self-fulfilling prophecy.

It is the third kind of feedback – reflexive feedback, wherein a rise in the price of an asset positively impacts the fundamentals underlying that asset – that drives the most extreme bubbles.

So, which kinds of feedback are at work in the bond market today? Well, for starters, I don’t think irrational feedback applies. There’s certainly no groundswell of investors clamoring to jump aboard the bond bandwagon, and I don’t expect this to change for some time yet (if at all).

As for rational feedback, there is certainly an element of it driving bond purchases by foreign central banks, pension fund managers and carry traders. But in my experience, rational feedback tends to be a reaction to (or symptom of) a bubble, not a precursor to it; at any rate it is not sufficient to inflate a bubble on its own.

Finally, let us consider reflexive feedback. This is the subtlest case of the three, and the most interesting. Is there a mechanism for reflexive feedback in the bond market today?

I believe so. It works like this:

The Fed lends money to banks at 0%, hoping that the banks will turn around and lend to businesses and consumers. But why should the banks do this? They'd much rather buy bonds at 4% and make the carry. Of course some amount of funds does in fact go to businesses and consumers, and some amount goes into riskier assets (this year, for example, these riskier assets have included commodities and emerging market stocks). But as a proportion of the whole, these amounts are minuscule.

Meanwhile the Treasury issues gigantic amounts of debt and that's where the bank money goes. And it creates a self-reinforcing dynamic: banks buy bonds and keep long rates low; the Fed sees low long rates as evidence that the market does not anticipate inflation, and so keeps short rates low; the Treasury sees strong demand for government paper and weak third-party lending and concludes that more issuance is both acceptable and required; and the cycle continues.

Note that it is precisely the fact of low overnight rates that makes buying long bonds attractive for banks. And it is precisely the fact of healthy demand for long bonds that encourages the Fed to keep overnight rates low. That’s positive feedback in its cleanest form.

Again, this is not (yet) proof either way that a bond bubble exists. It is merely suggestive evidence that a necessary condition – reflexive feedback – is in place for such a bubble to inflate. I will review some other pieces of suggestive evidence in my next post.

Tuesday, 24 November 2009

In my opinion there are three necessary conditions that have to be in place for a bubble to inflate: fundamentals, technicals, and feedback. Let’s look at each of these in turn.

Preceding every bubble there is a boom: a justified increase in prices driven by positive fundamentals. In the aftermath of a bubble, it’s easy to mock the excesses that marked the bubble’s apogee (boo.com! ninja loans!) but all too often people forget the backstory. In fact there were very good macro and micro reasons why the tech sector boomed in the early 90s, and why real estate boomed in the early 00s; it wasn’t all froth.

So, have the fundamentals been positive for bonds? I think the answer is yes, they undoubtedly have. Here are some of the factors that have led to lower and more stable interest rates over the last few decades, in no particular order:

1. Improved monetary policy – specifically, central bank independence and inflation targeting – starting with the Volcker Fed2. The end of the cold war; reduced military spending; the peace dividend3. The lowering of global trade barriers and tariffs4. China’s entry into world commerce and its export of wage and retail disinflation5. The bear leg of the commodity supercycle6. Improvements in business technology, especially in inventory management1

But fundamentals alone are not the entire story. A number of technical factors have also supported bonds in recent years2:

1. The Bretton-Woods II equilibrium, in which countries on the periphery (Asia and the Middle East) lend money to (buy bonds from) countries in the center (North America and Europe) to finance the latter’s imports. 2. Aging baby boomers transferring capital from stocks to bonds as per life-cycle investment theory3. Risk aversion in the aftermath of the crash4. The dollar carry trade

Fundamentals and technicals working in tandem have driven 30-year yields from 15.5% in 1981 to 2.5% in 2008. That’s a boom in anyone’s book.

But is it a bubble? For a bubble to inflate, there’s a third, crucial element: positive feedback. I shall investigate this topic in my next post.

Footnotes

#1Paul Krugman puts it nicely: "Businesses spent two decades figuring out what to do with information technology, then found the answer: big box stores!"

#2Note that these are just some of the technicals that are currently in play; at other times in the bull run, other technicals have applied.

Monday, 23 November 2009

Believing or disbelieving in the bond bubble seems to have become a political choice, at least in the United States. I can’t recall such a degree of partisan frenzy in the debate over previous bubbles such as housing, tech stocks or commodities. And for good reason: any discussion of bond prices and interest rates leads inevitably to a discussion of budget deficits and Fed/Treasury policy, which – unlike say dotcom valuations – is ideologically fraught territory.

So, in the interests of full disclosure, and for what it’s worth: I am not a US citizen or resident, I do not pay US taxes or receive US benefits, I am not currently connected with the US financial industry (except as an external observer and generic investor), and I do not support any US political party. In short, I have no dog in this race.

All I want to do is understand what has happened, what is happening, and what will happen, insofar as (and no further than!) it helps me as a trader and investor. And my current understanding, based I hope on unbiased analysis, is that we are in the middle of a bond bubble. I think that interest rates may go lower over the short term, but that they will go higher – significantly higher! – over the medium to long term. My portfolio is positioned accordingly. If I get my predictions correct, I will make money; if I get them wrong, I will lose money. It’s as simple as that.

Bubbles fascinate me. Nowhere else will you find such a variegated proving ground for the vagaries of human psychology, nor such a vivid illustration of the wondrous complexity that is the market. The various tensions on display – between individuals and institutions; between incentives and emotions; between rationality and greed; between the short term and the long run; between macro economics and micro behavior; between fundamentals and technicals – offer limitless scope to the curious observer.

If the study of markets is the study of human nature, then the study of bubbles is the study of markets in microcosm.

But these essays have been, for the most part, abstract and analytical; they say little about the state of the world today. Not so the next few posts. In the coming week I would like to talk about a bubble that I fear is developing before our eyes. And it’s not a bubble in emerging market stocks or in raw materials; it’s in something much closer to home.

Again, regular readers of this blog will know or have guessed what I’m talking about: I believe that we have recently completed the transition from a boom to bubble in the market for long term US government bonds.

Extraordinary claims require extraordinary evidence. Hence I will take a break from the usual ‘weekly column’ format of this blog, and instead provide a sequence of shorter posts in which I will expound on my thesis in greater detail. Coming up first: background information and necessary conditions.

Thursday, 19 November 2009

In last week’s post I mentioned three stages in the evolution of a market:

Identifying full-blown bubbles is easy. What’s not so easy is identifying the transitions that bookend a bubble. It’s not easy to know precisely when a rational, fundamentals-driven boom will morph into an irrational, sell-to-the-greater-fool frenzy. It’s not easy to know precisely when an irrational frenzy will reverse into an equally irrational stampede for the exits.

These three stages – rational boom, frenzied bubble, irrational panic – are in fact just three out of a total of six stages in my own idiosyncratic (and highly unscientific) taxonomy of bull and bear markets. Here’s how it works.

The first stage in any bull market is what I like to call the bounce. A sector or asset class that has been moribund for years or even decades suddenly starts rising in price. This could be due to exogenous shocks such as regulatory or technological changes; it could be due to Schumpeterian creative destruction, wherein prolonged low prices have driven out the weak and created a breeding ground for strong innovative companies; it could be due to simple cycles in supply and demand like the ‘commodity supercycle’. Whatever the reason – and often the operative reasons are not evident till many years later – prices begin to move upward. This is the bounce.

Typically during the bounce stage prices increase but the asset class remains unfashionable; only a few visionary investors recognize the bounce for what it truly is, the harbinger of a prolonged bull. Above all people don’t recognize the reasons for the bounce. Indeed, proselytizing for an asset class or sector during its bounce phase is a thankless job; you will probably get sniggered at by television talking heads for your trouble.

The second stage in a bull market is what I like to call the boom. During this stage, price rises have begun to attract more attention from the investment community. This is a stage of diffusion: the investment story spreads beyond its first few evangelists to an ever-increasing audience of relatively well-informed investors. To a large extent the strength of the sector becomes conventional wisdom. But prices continue to rise; it is not that contrarianism (going against the conventional wisdom) has failed; it is merely that the fundamentals continue to be so strong that they outweigh any technical factors.

The third and last stage in bull market is what I like to call the bubble. In this stage, the fundamentals have ceased to matter. In fact, the growth of the boom years has created sufficient supply to cause fundamentals to tilt to the opposite direction. But nobody notices. Drawn by strong performance, ever more investors flood into the sector. High prices create their own self-reinforcing dynamic. Positive feedback, mass self-delusion, ‘this time it’s different’, new paradigm stories, ‘permanently higher plateaus’, huge quantities of supply, sectoral employment shifts, dodgy startups, reality TV shows, easy funding – these are all symptoms of a bubble phase.

It’s pretty easy to distinguish between the three stages of a bull market. Certainly nobody could mistake a bounce stage (in an obscure and unfashionable sector) for a boom stage (where the sector is widely known for its strong fundamentals, albeit less widely invested in). Still less could anybody mistake a boom for a bubble: in a boom the fundamentals still rule, in a bubble fundamentals have gone out the window and the greater-fool theory rules. (Though well-meaning but misguided analysts inevitably try to justify bubble-era prices and try to coax the market into some sort of fundamental-based story; this usually involves invoking a new type of fundamental).

Just as a bull market has three stages, so too a bear market. The three stages of a bear are fairly accurate mirror images of their bull correlates.

First comes the blowup, in which the excesses of the bubble are purged. This purge is often quite dramatic, as the positive feedback loop that fueled the expansion reverses direction, causing prices to fall as precipitously as they previously rose. The excess liquidity that helped inflate the bubble is withdrawn with quite astonishing rapidity, leading directly to various closely related phenomena that are emblematic of a panic: the flight-to-quality reflex, the cash-is-king psychology, and the dynamic of the liquidity-death-spiral.

The next stage in the bear market is the bust. This is a long drawn out decline in prices as the market works out its overhang of excess supply (created in the boom) and anemic demand. The bust can last for years or (if markets are not allowed to clear) even decades.

The final stage of the bear market is the bottom. This is not a single point but a very lengthy period in which investor interest wanes, volumes and volatility decline, and sector news gets relegated to the inside pages of the financial dailies. Of course the bottom merely sets the scene for the next stage in the market, the bounce of the next bull market. And thus the circle is complete.

Thursday, 12 November 2009

In an opinion piece written for the Financial Times on Monday, former Fed governor (and current Columbia professor) Frederic Mishkin argues that central bankers cannot reliably identify asset-price bubbles; that certain types of bubbles – specifically, those without a credit element, which Mishkin calls ‘pure irrational exuberance bubbles’ (sic) – do not do much harm when they pop; that central bankers should not, in fact, try to pop the latter type of bubble; and that when in doubt a central banker should err on the side of benign inaction.

Implicit in all these arguments is the Greenspanist view that policy is better suited to mitigating the painful after-effects of a popped bubble, than it is to spotting and deflating the bubble in the first place. I was under the impression that this particular stance had been discredited along with the rest of Alan Greenspan’s philosophy of central banking, but evidently not. Here are the relevant quotes from Mishkin’s piece:

Because the second category of bubble does not present the same dangers to the economy as a credit boom bubble, the case for tightening monetary policy to restrain a pure irrational exuberance bubble is much weaker. Asset-price bubbles of this type are hard to identify: after the fact is easy, but beforehand is not. (If policymakers were that smart, why aren’t they rich?) Tightening monetary policy to restrain a bubble that does not materialize will lead to much weaker economic growth than is warranted.

I find these arguments deeply unconvincing, and not just because it is precisely this line of reasoning that has led us to crisis after crisis in the financial markets. Let us leave aside for the moment the contentious question of what action (if any) a central bank should take to restrain a developing bubble, or to ameliorate the consequences of its collapse. (I do have an opinion on this question but will save it for a later post). Instead let us ask a simpler question: Is it in fact credible to claim, as Mishkin does, that central bankers cannot identify a bubble in the process of expansion?

I think not. I think it is fairly obvious that Mishkin is being disingenuous. The problem is not that the Fed is unable to spot bubbles, but that it is unwilling to do so1.

Because the truth is, identifying bubbles is easy. When speculators use post-dated checks to buy stocks and sellers accept these checks because they assume the market can only go up: that’s a bubble. When an obscure fishmeal manufacturer offers a billion dollars to buy an internet portal: that’s a bubble. When people with no income and no assets are offered their choice of loans with which to buy million-dollar homes: that’s a bubble.

I repeat: identifying full-blown bubbles is easy. What’s not so easy is identifying the transitions that bookend a bubble. It’s not easy to know precisely when a rational, fundamentals-driven boom will morph into an irrational, sell-to-the-greater-fool frenzy. It’s not easy to know precisely when an irrational frenzy will reverse into an equally irrational stampede for the exits.

But here’s the thing: nobody is asking central bankers to do this. Central bankers do not need to time bubbles perfectly (that particular cross is solely for contrarian traders to bear). Central bankers merely need to recognize when they’re in a bubble, and take action accordingly. This is a much easier task.

Mishkin elides this distinction. When he implies that recognizing a bubble is equivalent to timing it (“If policymakers were that smart, why aren’t they rich?”), Mishkin is pulling an ingenious (and underhanded!) bait-and-switch on his readers. I can only hope that his views do not reflect either the prevailing wisdom at the Fed, or its attitude towards the taxpaying public.

Footnotes

#1Why might this be the case? For a host of political, institutional and structural reasons, most of which boil down to one simple fact: bursting a bubble is unpopular and painful. And ever since Paul Volcker retired, the Fed has consistently shied away from any course of action that involves exchanging short-term pain for long-term gain.

Monday, 9 November 2009

Yesterday, I thought I was coming down with something - I had a sore throat when I went to bed, and I woke up this morning feeling kind of blah. So, I thought I'd muddle through my classes (unfortunately, it's my long teaching day), and then come home and go to bed. By the end of the day, I felt like I'd been beaten with a stick - sore and feeling heavy-limbed all over.

But, it was the Unknown Daughter's birthday, so we had festivities first.

Then, I thought I'd put in a little work on before going to bed. Big mistake.

I started working on some spreadsheet models for my Fixed Income class at about 9 (just for an hour or so, I thought). Before I realized it, it's 3 a.m., and I've stayed up too late once again.

So far, I've made two spreadsheet models. One calculates duration and convexity for any combination of coupon, maturity, frequency, and yield, along with some graphs. The other calculates the average life of a mortgage pass-through based on various prepayment assumptions (multiples of PSA). While they're not pretty (I'm not exactly a wizard at formatting), I'm pretty happy with them, because they both use fairly complicated (for me) nested IF statements.

Next up will be a model for a sequential-pay CMO. That should be fun.

I'll end up eventually turning all the models into video tutorials (probably over the break), and will assign them for the students to replicate the next time I teach the class.

My basic approach to teaching is that if they can't calculate it, they don't understand it. So hopefully these will help.

Sunday, 8 November 2009

Human beings are good at interpolation, passable at extrapolation, bad at identifying inflexion points, and downright terrible at processing one-off events. It’s no coincidence that these skills are, sequentially, associated with increasing investment success: the harder it is to do something, the more money one makes for doing it.

This particular progression from easy to difficult is not merely the artifact of some deep-seated behavioral tendency or evolutionary bias. Deterministic and presumably unbiased algorithms, faced with unprecedented events, perform just as badly as humans. This is only to be expected: the very word ‘unprecedented’ implies that there is no baseline to build from or compare with, a circumstance under which most algorithmic approaches tend to flounder.

Unfortunately for all concerned, real life is full of one-off events. What we call history is, as Rudge memorably puts it, just one bloody thing after another. And that’s precisely why I’m suspicious of attempts to mindlessly trawl through past data for aggregate patterns. Every episode is different; every episode is new.

This does not mean that history should be discounted entirely. Quite the contrary. A deep and broad knowledge of history (and not just the history of the markets!) is essential to becoming a successful trader. Events may not repeat themselves exactly, but they certainly rhyme; the trick is to find out what they rhyme with.

So how does one accomplish this trick? Regular readers will know the answer: by asking ‘why’. Questions such as ‘what’ or ‘when’ or ‘which’ or ‘how much’ are no doubt useful when it comes to short-term, tactical trading, but they are limited in their ability to throw light on long-term, strategic trends. Asking ‘why’ a particular historical event turned out the way it did, on the other hand, is the first step towards recognizing its kinship (or lack thereof!) with seemingly similar events developing today. Understanding the past is the key to understanding the present, to say nothing of predicting the future.

This sounds overly abstract but in truth it is anything but; the technique of asking ‘why’ at all times can (and should!) be used to analyze not just big-picture historical movements, but also individual trades. Indeed, finding out why a particular trade worked while others failed is a key component of the trader’s art.

Here’s an example from my own career trading bonds. My portfolio was, in general, designed to capture or monetize excessively rich risk premiums (curve, liquidity, capital structure, you name it). Risk premiums of course tend to widen in times of market stress, so my portfolio behaved as if it were short event risk. To hedge against this I invariably had a long position in Fed Funds futures and the first few Eurodollar contracts, confident in the knowledge that any ‘flight-to-quality’ would send these assets higher. (Also, in truly extreme cases the Fed could be counted on to step in and cut rates, helping the front of the yield curve.)

Being long fixed income is like a synthetic long gamma trade. More than 90 per cent of the time, if there is a major dislocation to the economy, fixed income will rally. I sleep better at night doing that.

Insurance is not the only reason to be long bonds. There’s also the widely-held belief that rallies tend to be slow grinding affairs while selloffs tend to be sudden sharp shocks1; it’s a lot easier to ride the former than it is to time the latter. Here’s Siva-Jothy again:

Bear markets in fixed income are very short with powerful rallies. You can make money during a bear market but you have to time your trades perfectly.

As a matter of fact, most successful bond traders of the recent past, like Siva-Jothy, have had a perpetual long bias, and have justified it on similar grounds.

Looking back though, I wonder if this is not just post facto rationalization. After all, the Treasury market has been rallying more ore less continuously for the last quarter of a century; long bond yields have gone from 15.5% in 1981 to 2.5% in 2008. You would have had to be a spectacularly incompetent long-biased trader not to make money over this period. Conversely, no matter how good you were at trading from the short side, you’d have been hard pressed to make big returns in such a strong bull market. And that’s why most bond traders, through experience or by selection, tend to have a bullish stance2.

All very well, but so what? So this: what if bonds turn? What if the 30-year bull market was a one-off event that will not be repeated, rather than a trend that will continue3? What if 2008 marked the low in bond yields? What if rates stay steady or trend higher over the next decade or two? Will the front of the yield curve still serve as an event hedge? Will rallies continue to be protracted and selloffs continue to be compressed? Right now, nobody knows for sure, but these are questions worth keeping in mind. A trader who does otherwise – who merely trades from the long side without asking why being long Treasuries worked in the past – risks being blindsided.

#2Of course, this explanation merely pushes the question back one level. Why did the bond market rally for 25 years? That’s a question that deserves a full-length post in answer.

#330 years is, admittedly, a long timeframe for a ‘one-off’ event, but note that the current bull market was preceded by the greatest bear market in US Treasury history. Perhaps the entire rally in rates since 1981 is merely reversion to the long-run (pre-bear) mean.

Wednesday, 4 November 2009

Disclaimer: the following post is not for the faint of heart (or for those who have an overly developed sense of propriety). But then again, most of my readers aren't in those categories anyway.

Since I recently turned 50, I got to have that little procedure that comes with the turf - a colonoscopy. The actual deed wasn't bad at all, but the prelude was, shall we say, less than enjoyable. Since the docs want a clear "field of play". they make you go on a clear-liquid diet for the day prior to the procedure. So, I got to teach 3 classes on a diet of Jello, black coffee, and chicken bullion - not the easiest thing to do.

More importantly, they give you what they call "prep". the best way to give you a feel for what that involves is to point you towards this this classic video (warning: may not be safe for work - so turn the audio down a bit). The "prep" is essentially laxative mixed with rocket fuel. On the bright side, I got to read a couple of books I hadn't recently had time for while "parked" in the little room.

In any event, the actual procedure went fine, and there was nothing of concern down below deck. All I can say about it is "thank goodness for high-quality sedatives" - I went to sleep just before they started, and woke up in the recovery room after, with no memory of anything.

Once it was done, I grabbed lunch and went home to sleep off the remaining effects of the sedative (this took most of the afternoon). Of course, there was only one food that was appropriate for the first mean after waking. Luckily, since I married well above myself, the Unknown Wife was ready with pancakes and BACON for dinner.

For those of you that want a better sense of what the whole thing was like, no one says it better than Dave Barry. Just don't read it with any liquid in your mouth, or you'll be cleaning off your monitor (seat belt, indeed!). Then go sign up for a colonoscopy, if you are over 5o and haven't had one yet.